Options are derivative instruments based on underlying securities, such as stocks and bonds. Calls and puts are the two basic types of stock option contracts. Calls give you the right to buy the underlying shares at specified prices, known as strike prices, before predetermined expiration dates. Puts give you the right to sell the underlying shares at specified strike prices before expiration.

Basics

Options trade on a limited number of stocks, and they trade in lower volumes than stocks do. Options usually expire in nine months or less, although some long-term equity anticipation securities have longer expiration times of up to three years. Each stock option contract is usually for 100 underlying shares. The premium is the market value of an option contract. The cost to acquire a call or put option is the premium multiplied by 100, plus broker commissions. Options fall in value the closer they are to expiration.

Use

You would buy call and put options if you think the underlying stock price is going to rise or fall, respectively. You would also buy call and put options to hedge short and long positions in the underlying stock, respectively. A long position means that you own the stock. A short position means that you have borrowed shares from your broker and sold them because you expect to buy them back later at a lower price. Call options can hedge short sales because you can buy back the stock at the strike price if the stock price rallies sharply. Similarly, put options protect long positions because the options rise in value if the underlying stock price falls and you could exercise your right to sell the shares at the higher strike price.

Rewards

Call options have unlimited profit potential because the underlying stock prices could theoretically rise forever. Put options have limited profit potential because stock prices can only fall as far as zero. Call and put options rise in value when the underlying stock prices rise and fall, respectively. A call option is in-the-money or profitable when its strike price is below the stock price. It is out-of-the-money or unprofitable when its strike price is above the stock price. A put option is the opposite: it's in-the-money when its strike price is above the stock price and out-of-the-money when its strike price is below the stock price.

Risks

The risk for call and put option holders is limited to the premium paid. You could risk losing your entire investment if the stock price stays below the strike price for call options and above the strike price for put options. You could minimize your losses by selling your call and put positions prior to expiration, assuming there is still a market for them. It becomes difficult to find buyers for options, however, as they get deeper out-of-the-money.

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About the Author

Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.

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